Inflation is Coming

Ben Bernanke announced that second round of quantitative easing (QE2) in November 3, 2010. Fed will print $600 billion dollars and use them to purchase bonds in the open market. QE2 supposes to fight deflation. However, it raises the potential of high inflation if Ben Bernanke over-shot the target. There are signs of incoming inflation. Below is the commodities table in November 16, 2010’s USA Today’s money section:

Natural Gas is the only commodity which does not have a price increase in 2010. Producers do not have much leverage to raise product price at this time. They absorbed the increased cost in their process with lower profit margin. You can see the effect in numerous reports, such as Dean Food complained higher cost of mike and butter; Pilgrim’s Pride Chicken complained about higher corn price, etc…

Consumers haven’t seen retail prices increased yet because producers can not pass increased cost to retailers. However, consumer prices will jump as soon as retails feel they have regained pricing power. It is more worrisome that QE2 and its siblings may devalue dollar. Cheap imports from China and other countries hold down US inflation. With US exchange rate going lower, import will be more expensive. If China floats its exchange rate to US dollar, US consumers, which purchased billion dollar worth of Chinese imports will be worse off. Inflation could be out of control.

In the worse case scenario, other countries lost confidence on US dollar. Instead of holding US dollar in their reserve, they use it to purchase US assets. China holds more than 2 trillions of US dollars. That will unleash a tsunami of inflation.

Actually, a high inflation rate maybe good for US government. Inflation decreases actual US deficit without raise taxes. However, it is still highly likely that US government will increase tax to pay for national deficit in the future. Labor secretary under president Clinton and former economic adviser to President Obama’s,  Robert Reich suggested new marginal tax rates for full time workers. All incomes are treated the same:

1. Reversed income tax like Earn Income Tax Credit (EITC). Any full time worker earns less than $20,000 in 2009 dollar will get $15,000 earn income tax credit. The EITC becomes $0 for income $50,000 or higher.
2. 10% tax rate for income between $50,000 to $90,000.
3. 20% tax for income between $90,001 to $160,000.
4. Top 5% income earners with income between $160,000 and $260,000 pay 40%.
5. Top 2% income earner with income between $260,000 and $410,000 pay 50%.
6. Top 1% income earners with income above $410,000 pay 55%.

Ways to combat high inflation and higher taxes for individual

Strategies combating future higher tax

1. The best way to combat higher tax is avoiding them altogether legally. Roth IRA is an option available for most working American. You invest with your after tax money. All your gain is tax free when you withdraw it. However, you can only invest around $4,000/year into you Roth IRA.  We hope US government keeps its promise not to tax Roth IRA gains in the future as suggested by Robert Reich.
2. Education Saving Account (ESA) works like Roth IRA, but you can only contribute $2,000/year per child (as year 2011). You have to use all the money in the account by your child’s 30th birthday on qualified education expenses.
3. 529 plans for child’s education. Some 529 contributions are exempted from state income taxes.
4. Defer tax to after retirement. Hopefully your lower income then puts you into lower income tax bracket. 401K and HSA (Health Saving Account) are two options available for most income earners.

Strategies combating potential hyper inflation
It is possible that 1980s high inflation of 10% or more will come back in the future. Here are some ways to combat it.

1. Lock in revenue generating properties at today’s low interest rate with long payment terms. Corporations issue long term debts with interest rate less than 4%. Rent producing, cash flow positive house or apartments are good choices for individual investor.
2. If owning property is not your cup of tea, you can purchase real estate investment trust (REIT) stock or mutual fund. REIT companies can raise rent when inflation is high.
3. Buy high quality foreign stocks, especially from countries with more export than import. With high US inflation, US dollar will be weaken against exporting countries’ currency. In addition to hedging inflation, you also benefit from increasing exchange rate. Peter Schiff recommends in his book Crash Proof 2.0 that conservative stocks from Canada, Australia, New Zealand,  and maybe South Africa, Scandinavian countries like Norway, and Hongkong and Singapore are good choices.
4. Buy high quality stocks, especially from companies with more international exposure. High quality companies can raise product price with inflation.
5. Buy gold, silver, or other commodities to hedge inflation. However, this is hard to do for individual investors especially after gold and silver rose more than 30% in 2010. Platinum (PPLT) is a safe choice as well. Platinum has more industrial use than gold.
6. Purchase Government Inflation Protect bond (TIPS). However, the interest rate for recent bond (9/15/2010) is low, 3.99% for 10 year TIPs.
7. Purchase high rate bond (junk bonds). The bond’s return should beat the inflation. However, it carries default risk. Pick your bonds carefully. Vanguard High-Yield Corporate (VWEHX) and iShares High Yield Corporate Bond Fund (HYG) with 8.98%, JNK with 10.8%
8. If hyper inflation look probable, Peter Schiff recommends investor move cash into international currency.

Reference

1. 1. http://www.reporterslive.com/867-european-union-workers-say-no-to-austerity.html
2. Why the Maven Is Morose. This is an excellent article from Barron’s with some excellent comments.
3. Rethinking Gold: What if It Isn’t a Commodity After All? This article points out that gold price shows dollar losing strength.
4. Inflation Lobby is about to win the Argument gave more balance view of why inflation is coming.